Despite Their Disclaimers, Banks Have Taken on Risker Derivatives

Bankers like to tell their public that they use derivatives mainly for risk-management purposes, but their actions may suggest otherwise.

Regulatory statistics show U.S. banks are slowly but steadily moving away from the less risky type of derivatives contract - those publicly sold on exchanges - and more toward confidential agreements negotiated with Wall Street firms that expose them to credit and counterparty risk.

Though reluctant to discuss derivatives strategies since the complex instruments caused some well-publicized debacles in 1994, banks may now have some explaining to do.

Leaving out Citicorp, which has seen an increase in the exchange-traded variety, seven banking companies that account for 92% of derivatives in the U.S. banking system reported declines in that type during the third quarter.

Data from the Office of the Comptroller of the Currency showed a 4% drop in the top 25 commercial banks' exchanged-traded contract volume during that quarter.

Custom over-the-counter contracts, which account for the majority of banks' notional derivatives value, grew, and traders expect the trend to continue.

"It demonstrates how the unregulated, dynamic market is improving in efficiency," said Charbel Abouchared, head of U.S. derivatives trading at CIBC Wood Gundy.

Some bankers contended that derivative contracts bought from places like the Chicago Mercantile Exchange are safer than those arranged through Wall Street institutions. With an exchange acting as intermediary, buyers are not directly exposed to the financial well-being of counterparties.

"In many ways, exchange-traded contracts are preferable," said John Logan, executive vice president at First American Corp., Nashville. "They're more efficient, and there's no credit risk because you must post margin every night."

Derivatives are instruments whose value is attached to the performance of something else, such as an interest rate, foreign exchange rate, or stock. Banks most often use derivatives to hedge against changes in interest rates.

According to call reports filed with the OCC, 86% of the $19.8 trillion in derivatives' notional value comes from "over-the-counter" contracts tailored by dealers for their clients.

"I'm surprised to hear that," said Andrew Lese, vice president at Emcor Risk Management, an Irvington, N.Y., consultancy. "I would have thought banks would be using the exchanges more because of concerns with credit and exposure to counterparties."

So why are banks becoming more exposed to credit and counterparty risk? Flexibility is one reason.

Unlike exchange-traded contracts, privately negotiated over-the-counter agreements are not regulated. They can be tinkered with to meet a bank's schedule or needs.

"When we do swaps, we have specific dates we like to assign," said Steven Bluhm, senior vice president for funds management at Banc One Corp. "We can also add securities agreements, which we sometimes like to do."

Another reason banks prefer dealer-designed derivatives has to do with investor perceptions. Banks that buy derivatives contracts from exchanges may look as if they are taking on more risk than they really are.

And derivatives still alarm many investors - not to mention bankers. Mr. Bluhm, whose bank experienced $170 million of derivatives-related losses in the fall of 1994, calls them "the scarlet D."

One way banks approach derivatives is through an agreement with a trading bank to swap a fixed for floating rate of interest. The bank then exchanges with its counterparty the difference between the fixed and floating rates of interest for the duration of the contract.

It is impossible to determine how much banks pay for this service, Mr. Bluhm said, because profits or losses do not get reported until agreements end, which can take years. Banks have strongly opposed proposals by the Financial Accounting Standards Board to shed more light on these contracts by calculating fair market value and reporting profits or losses quarterly.

The Eurodollar market offers another, less exotic, but no less effective way for banks to lock in interest rates.

Banks receive a fixed rate of return every time they sell these futures contracts, whose prices are publicly quoted. Though their prices are published and credit concerns minimal, Eurodollar contracts are no magic bullet. The $1 million notional value of each contract is tiny compared to what a Wall Street dealer can offer.

Eurodollar contracts can't be readily structured for other purposes, such as leveraged agreements. And they are an accounting headache, bankers say, since banks must mark their positions to market every night.

Eurodollar contracts are also so short-term that businesses must pile up on them to hedge. As a result, the notional values that users must report to the Securities and Exchange Commission can reach frightening heights, First American's Mr. Logan said.

"Suppose you want to hedge a two-year risk," he said. "You'll have to buy eight three-month contracts. That's $24 million in notional value right away for a single hedge.

"You don't want these contracts to be 20% to 30% of your assets, which would happen if you used enough of them. That scares people."